There’s an updated Lightroom 4 version of these instructions in the Knowledgebase.
Extract from Adobe Lightroom 2 – The Missing FAQ
Yes, in fact it’s a very good idea to do so, and just have one or two top level folders. If Lightroom ever loses track of all of your photos, perhaps as a result of a hard drive failure, you will only need to re-link the top level folder and that will cascade through the rest.
So how do we go from this slightly nondescript tangle of folders…
to the tidy hierarchy….?
Right-click on the current top level folder and select ‘Add Parent Folder’. This doesn’t import new photos, just adds an additional hierarchy level to your Folders panel (and does a lot more behind the scenes…).
Keep clicking on the top level folder until you see the folder you’re looking for.
If you go too far and want to remove a top level folder, right-click on that folder and choose ‘Promote Subfolders’.
This does the opposite of ‘Add Parent Folder’, and will ask for confirmation before removing that top level folder.
Selecting ‘Remove…’ from the right-click menu gives you the choice of promoting the subfolders, but also gives you the option to remove all of the subfolders and their images from the catalog too, which you wouldn’t want to do when simply tidying up the hierarchy.